Tuesday, October 27, 2009

Status of dollar - an update

One of the biggest talking points in recent discussion about global economy has been the speculation about the dismal prospects for the US Dollar. However, such doomsday predictions may be premature and a more balanced assessment is required.

Since March, with uncertainty about the US economy, the dollar has been on a continuous decline against all the major currencies, except the Chinese renminbi.

The US Fed's loose money policy and swollen balance sheet, coupled with the ballooning government debt and record budget deficit, have only fuelled the speculation that the age of dollar as the dominant global reserve is over.

Conventional wisdom would have it that a declining dollar would put upward pressure on long term US Treasuries and widen the spreads on riskier dollar assets. However, bond market trends reflect the opposite, though the risk of a medium to longer term rise is yields looks possible.

Further, the US public debt (at 56% of GDP), while alarming in its rise, in absolute numbers, and in the share of short-term debt maturing in one year, appears to be on the lower side in comparison with that of other major economies, especially Japan.

And, thanks largely to the enormous size and credibility of its financial markets and economy (both of which will require some recurrances of the recent events to dissipate away) and the inherent advantage of having a domestic currency which is also the preferred global reserve currency, its sovereign bond rating remains as strong as ever. However, further slippages in public debt, beyond the 100% of GDP mark, could force ratings downgrades and raise the borrowing costs and debt-service burdens.

The one big concern for the US economy and dollar would have come from a possible rise in interest rates in the face of inflationary pressures. However, as Paul Krugman, has argued here, in all likelihood, deflation will be the much bigger concern for US policy makers and the need for raising interest rates looks remote.

The biggest plus from the declining dollar is that it would enable the US to bridge its trade deficits and thereby contribute, atleast partially, towards remedying the global macroeconomic imbalances. And indications are that the US trade deficit is shrinking in response to the depreciating dollar.

A weaker dollar is primarily a reflection of the weak US economy, especially in relation to the emerging economies. Further, given the ongoing recalibration of the global economic balance of power due to the stunning rise of the China-led emerging economies and the serious loss of credibility suffered by the US financial system from the sub-prime mortgage crisis, the dollar's decline from its preminence of the last fifty years was inevitable. Though it will remain the biggest global reserve currency, there will be much greater competition from the other major currencies in the years ahead.

Here too, the relative economic weakness of Euro zone and Japan, will leave a vacuum that may leave the forex markets in a state of flux for the foreseeable future. Interestingly, though dollar's share of global forex reserves fell to 63% in mid-2009 from 72% in 2001, most of it was due to decline in its value, not reduced demand. Ironically, a cheap dollar will incentivize Central Banks to buy more dollars in expectation of increase in domestic currency returns from dollar assets.

See this Economist article on the varied set of responses to the declining dollar from Japan, EU, China and other emerging economies. And Krugman points to another reason for having a depreciated dollar to remedy the global macroeconomic imbalances.

Update 1
Christian Broda, Piero Ghezzi, and Eduardo Levy-Yeyatiit claim that the dollar may strengthen in 2010 if the Federal Reserve exits quantitative easing sooner than its counterparts and the US economy enjoys a strong rebound.

Update 2
Paul Krugman points to the trend decline in the value of dollar since 2002, and feels that any CHinese dumping of dollar (or selling its Treasury holdings) would only mean that the Chinese do quantitative easing on behalf of the US.

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